What is a Hidden Franchise Under Hawaii Law?

A federal court in Hawaii recently issued an opinion finding that a distribution agreement is not a franchise under Hawaii's Franchise Investment Law. The defendant in the case, Pace-O-Matic ("Pace") is the manufacturer of gaming devices, which include "skill stop" gambling machines.

The plaintiff, Prim, LLC entered into a distribution agreement with Pace to become the exclusive distributor for Pace's "amusement devices" in an area that included Hawaii.

In October 2010, Pace sent Prim a notice of default, and terminated the exclusivity portion of the agreement between the parties. Prim sued in the U.S. District Court for the District of Hawaii. Among other things, Prim asserted that Pace violated Hawaii's Franchise Investment Law (Haw. Rev. Stat. §480-2 et seq.) by failing to deal with Prim in good faith and by terminating Prim's franchise without good cause.

Pace sought summary judgment on that claim, arguing that there was never a franchise between Prim and Pace, and that Prim never paid Pace a franchise fee.

The Court noted that, under Hawaii law, a franchise consists of an agreement "in which a person grants to another person, a license to use a trade name, service mark, trademark, logotype or related characteristic... and in which the franchisee is required to pay, directly or indirectly, a franchise fee." Haw. Rev. Stat. §482E-2.

Examining the Distribution Agreement, the Court found that the contract did not provide that Prim could use Pace's name, trademarks, or proprietary software, and that instead Prim's role under the contract was to "purchase games" from Pace and "exercise its best efforts to develop markets for the games and distribute" them.

Citing the U.S. Court of Appeals for the Ninth Circuit's decision in Gabana Gulf Distribution, Ltd. v. Gap Int'l Sales, Inc., 343 Fed. App'x 258, 259 (9th Cir. 2009), the Court noted that a distributorship is "not the same thing as a franchise relationship." In this regard, the Court noted that "[t]he very essence of a franchise relationship is that the franchisee represents the franchise to the public; a franchise is not created whenever one company purchases and distributes another company's products."

Considering that the Distribution Agreement only allowed Prim to purchase Pace's products, and did not permit Prim to "substantially associate" with Pace's trademarks, the Court found that the Distribution Agreement did not create a franchise.

The Court also found that Prim did not pay Pace a franchise fee. Under Hawaii law, a franchise fee is "any fee or charge that a franchisee . . . is required to pay or agrees to pay for the right to enter into a business or to continue a business under a franchise agreement," but does not include "the purchase or agreement to purchase goods at a bona fide wholesale price." Haw. Rev. Stat. §482E-2.

The Court cited its previous opinion in JJCO, Inc. v. Isuzu Motors America, Inc., 2009 WL 1444103, at *4 (D. Haw. 2009), aff'd, 2012 WL 2584294 (9th Cir. July 5, 2012) for the "guiding principle is that, unless the expenses result in an unrecoverable investment in the franchisor, they should not normally be considered a fee." The Court found no evidence suggesting that the money paid by Prim to Pace for products was anything other than a bona fide wholesale price, or that it constituted an "unrecoverable investment" in Pace.

Based on its finding that the Distribution Agreement did not create a "franchise" within the meaning of Hawaii law, the Court granted summary judgment for Pace on that claim.

The case is validation for companies that operate through networks of independent distributors. Where the distributor: (1) is not permitted to "substantially associate" its business with the manufacturer; and/or (2) pays only the bona fide wholesale price for its merchandise (and no other form of compensation) to the manufacturer, the relationship will typically not be considered a franchise under state laws.

That being said, the "hidden franchise" problem can exist any time a business wishes to structure its model to avoid being considered a franchise. There are many traps for unwary business owners in this area of the law; as a result, it's critically important for a distribution business seeking to avoid being labeled as a franchise to consult with an attorney experienced in franchising before using any particular business model.